Individuals and businesses have long complained about California’s high tax rates. California’s top 13.3% bracket for personal income tax is the highest among the 50 states, and the corporate income tax rate of 8.84% is near the top (only Alaska, Iowa, Illinois, Minnesota, New Jersey, and Pennsylvania have higher corporate rates). With all this complaining, it’s no surprise that many taxpayers have considered leaving California for more tax-friendly environs, especially since California lawmakers have put forth several tax increase proposals, including a top individual rate of 16.8% and a 0.4% wealth tax. There are even proposals to alter the longstanding Prop 13 property tax protections with respect to residential, commercial and industrial real property.
The vast majority of California taxpayers would not be affected by the current proposals. California, like the federal government, has a marginal rate tax system, so only individuals earning income beyond a certain threshold would see their taxes increased. Currently, the 13.3% income tax bracket only applies to net income in excess of $1 million. The proposed hike would increase the rates to 14.3% on income above $1million, 16.3% on income above $2 million, and 16.8% on income above $5 million. Likewise, the proposed wealth tax of 0.4% would only apply to those with fortunes over $30 million. Proposed changes to Prop 13 with respect to commercial and industrial properties would only affect properties worth more than $3 million; residential property would still be protected from fair market value assessments. Finally, the proposed changes to the parent/child exclusion for residential property reassessments – while eliminating the lifetime $1 million lifetime exclusion for all property — would still allow children receiving property from parents used as a primary residence to pay property tax at below-market rates. Nevertheless, many wealthy Californians are considering their options.
Leaving is easier said than done
California law requires that its residents — people living here or out of state for a temporary or transitory purpose — pay state income tax on their worldwide income. California zealously enforces its tax laws, especially when it comes to auditing taxpayers who claim to have left the state. Many taxpayers have attempted to “leave” the State under the mistaken belief that living outside California for more than half the year is sufficient to escape residency. In fact, the amount of time you spend in of California is only one factor. Other factors include where other family members live/work/attend school, the location and value of your residential and investment real estate, where your business is conducted or where you are employed, the location of your bank accounts, where you hold professional licenses, where you are registered to vote, where you maintain a driver’s license, and even where your doctors, dentists and other professionals you use are located. Although California’s regulations provide a safe harbor for individuals whose presence in this state do not exceed an aggregate of six months during the year, meeting this safe harbor also requires (1) having domicile and a permanent abode in another state, and (2) not engaging in any activity or conduct in California other than that of a seasonal visitor, tourist or guest. Essentially, meeting the safe harbor requires that you have no contact with California beyond a vacation home and country club membership.
The State has broad authority and powers to demand documentation regarding your activities, from cell phone records and credit card statements to your voting history and membership in health clubs and churches, and will go to great lengths to assert that you have not truly given up residence here. Expect the State to prepare a detailed report of your physical presence, assets and community ties in an effort to claim that you either intend to return or have not truly moved out. In short, successfully proving that you have left California requires a lot more than just buying a second home in another state; rather, it requires demonstrating that you have truly severed your connections here, and have established closer – and permanent – connections to another state. Even if you successfully demonstrate that you are no longer a resident, you may still owe tax on half your income if your spouse still resides here since community property rules treat half your income as belonging to your spouse. In short, making a move out of state without thorough planning may result in having to pay the tax you were trying to avoid, together with interest and penalties.
Migrating your business out of state is no guaranty of escaping tax
Many taxpayers — including employees, independent contractors, and business entities — have also considered leaving California to avoid tax. First, merely incorporating or organizing an entity in another state will not prevent California from asserting that you are “doing business” here. Even worse, conducting business in California without registering here can strip your business of the right to enforce contracts, defend lawsuits, and strip you of the liability protection normally afforded by running your business through a separate entity. Second, changes to California law enacted in 2013 now provide that businesses who make sales or provide services to California customers have California-source income, which could result in an out-of-state business owing tax here even if there is no physical presence here. Interestingly, this change to the law — known as market sourcing rules — now also provides California companies with multistate customers the ability to minimize corporate taxes by apportioning income to other states. If you are planning on leaving California, but your business would continue to have sales to California customers, you are likely to find that you will still be taxed by California to the extent your income is sourced here under market sourcing rules. This could apply whether your business is run as a corporation, partnership, LLC or even as a sole proprietorship. While the new market sourcing rules are complex, they do provide opportunities for minimizing the tax due.
First, determine how much tax you would actually save by leaving California; you might find that the potential tax savings might not be worth leaving friends and/or family and the Golden State behind. If you believe leaving is in your best interest, then forethought and preparation is key if you do not want an unwelcome tax bill in the future.